Originally, I planned on writing a post on the tradeoffs of thematic investing at the seed stage. As I was making notes, I landed on a working theory about the career arc of a venture investor. It may follow a trajectory similar to the Gartner hype cycle with a peak and trough, followed by eventual stability.
The temptation of a top-down approach coupled with feedback from opportunistic moments factor into a larger story about the investing journey. This frame is based off my personal (and narrow!) conversations and experiences over the past few years — I’m open to feedback.
The initial learning curve has two dimensions — learning the business and learning the game. People entering the venture business aspire to be smart and ambitious, and there’s much to digest about evaluating products & markets, along with developing judgment for talent. As much as I’d like the business (supporting founders, making investments) to be the same as the job; it’s only one part. The other piece is the game — navigating the social mores of Silicon Valley, building enough context for decision making, and finding one’s sources of informational, behavioral, and analytical edge. Uncertainty operates on many levels — time & schedule, tasks, objectives, and the definition of success.
Peak of Inflated Expectations
After time and adjustment, the fog seems to clear. Guided by a peripheral vision of the market, patterns begin to emerge in pitches, investments, entrepreneurs. Due to the velocity of early-stage investing, one has interacted with hundreds (if not thousands) of companies within a couple years. One may taken an overly thematic point of view based on holes and opportunities they see in the market. I’ve noticed that most theses (including many of my own) floating around in the tech ecosystem predominantly stem from funding activity at seed and Series A. Hot deals with multiple term sheets serve as our guide into the future. It’s tempting, but fickle, ground to stand on.
Since real signals are drawn out in the future, people look to immediate proxies of success on which to judge an investor. This could be the calibre of co-investing funds, or even quality of content on Twitter. However, it is unlikely an investor has seen real liquidity early on, and successful investments primarily live on paper gains.
Trough of Disillusionment
One of the first concepts to stomach is that most startups end up not working out. But, the lesson that comes after is even harder to process. One may expect binary outcomes — you invest in a company, and it takes off like a rocketship. Alternatively, you immediately know a company will not succeed right after the investment.
In reality, randomness largely governs your portfolio. Some companies seem like they’re on a downward spiral for a few years, then miraculously turn it around. Others fly high for a long time before plateauing. It’s rarely cut and dry with exponential growth and sequential, ordered financing rounds. There may be large swaths of your portfolio that are uncertain for years. Fred Wilson has this idea of “The Second Quartile” I find fascinating. He writes,
“And then there is the second quartile that will produce roughly 15% of the returns of the fund. I find that it is this cohort of investments that is the most challenging to manage. The companies in the second quartile are usually very good companies but they lack the explosive value generation characteristics of the top quartile. They tend to have a harder time attracting top talent and financing their businesses at attractive valuations. We often do insider-led rounds for companies in the second quartile as the venture industry is hard wired to invest in the top quartile, particularly the later stage/growth investor community.”
I’m guessing this period a few years in is the make or break it moment. There’s a lot of not-so-glamorous work to be done where the investor’s reputation is at stake. As Fred points out, odds are the high flyers don’t need your help, but the other segments of the portfolio do.
The Final Segments
I’ll say less about the “Slope of Enlightenment” and the “Plateau of Productivity” because I know little about these phases. However, I’m fairly confident in a few things:
DPI, which measures the cash-on-cash return on investment, gives you a lot of street cred.
Experienced VCs tend to accept the role of chance and accept what is unknown to a greater degree than younger investors.
It takes about a decade to get here.
Appendix A: Finding Attachments
Due to the influx of capital into the early-stage ecosystem, it’s much harder to be a generalist venture investor than it was a decade ago. Why would the best founders want to work with you if you have a limited track record and no tangible associations? To combat this, junior investors lean towards specialization, attaching themselves to companies or ideas (in the form of market maps and theses) quickly. The potential cost is attaching oneself to the wrong markets due to the myopia mentioned above. The other danger is in setting and missing expectations. If you’ve branded yourself as a fintech investor, and you miss an iconic fintech deal — you’re caught in a tough position.
Appendix B: The Consequences of Being Right
There’s a “curmudgeon effect” within seed investing I find interesting. It’s a rare byproduct of investing at seed, but present nonetheless. A seed investor could pass on a company due to concerns about market size or belief in the venture viability of the business model. However, that business could grow top line revenue for years, keep consuming capital to grow, and become one of the hottest unicorns in the ecosystem, all with a structurally flawed model. Firms with early dollars in grow their AUM from the markups, but the skeptical investor has been right the whole time. On the subject of long feedback loops, it could take a decade for the business to fold.
It goes without saying that naysayers don’t belong in the venture business. It’s about optimism and faith in talented people, rather than trying to call the future. But, I’m sure there have been more than a handful of seed managers who have felt like Einhorn going against Allied at times.